Capitalization of Interest & Carrying Charges
Properly Allocable to Straddles

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [REG-105801-00] RIN 1545-AX92

TITLE: Capitalization of interest and carrying charges properly
allocable to straddles

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations that clarify
the application of the straddle rules to a variety of financial
instruments. The proposed regulations clarify what constitutes
interest and carrying charges and when interest and carrying charges
are properly allocable to personal property that is part of a
straddle. The proposed regulations also clarify that a taxpayer's
obligation under a debt instrument can be a position in personal
property that is part of a straddle. The proposed regulations
provide guidance to taxpayers that enter into straddle transactions.
This document provides notice of a public hearing on these proposed
regulations.

DATES: Written and electronic comments and requests to appear and
outlines of topics to be discussed at the public hearing scheduled
for May 22, 2001, at 10 a.m., must be submitted by May 1, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG-105801-00), room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered between the
hours of 8 a.m. and 5 p.m. to: CC:M&SP:RU (REG-105801-00), Courier's
Desk, Internal Revenue Service, 1111 Constitution Avenue NW.,
Washington, DC. Alternatively, taxpayers may submit comments
electronically via the Internet by submitting comments directly to
the IRS Internet site at http://www.irs.gov/tax_regs/regslist.html.
The public hearing will be held in the Auditorium, Internal Revenue
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed
regulations, Kenneth Christman (202) 622-3950; concerning submission
and delivery of comments and the public hearing, Treena Garrett,
(202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Sections 501 and 502 of the Economic Recovery Tax Act of 1981
(Public Law 97-34, 95 Stat. 172) added sections 1092 and 263(g),
respectively, to the Internal Revenue Code to address certain
deferral and conversion strategies involving economically offsetting
positions in actively traded personal property. These economically
offsetting positions are called straddles. Section 1092(c)(1).

In general, under section 1092, a taxpayer that realizes a loss on a
position in actively traded personal property must defer the
recognition of the loss to the extent the taxpayer has unrecognized
gain on an economically offsetting position in the property. This
deferral rule matches the recognition of loss with the recognition
of the economically offsetting income. Section 263(g) addresses
interest and carrying charges properly allocable to personal
property that is part of a straddle. Under this section, these
otherwise deductible expenses are not currently deductible. Instead,
they must be capitalized into the basis of the property. By
requiring capitalization, section 263(g) prevents: (1) a taxpayer
from gaining a timing advantage by accruing deductions associated
with carrying the straddle transaction before recognizing income
from a position in personal property that is part of the straddle;
and (2) the deductions from having a character different from that
of the income.

These proposed regulations provide certain rules with respect to the
application of section 263(g) and section 1092.

Explanation of Provisions

The proposed regulations consist of §1.263(g)-1, which provides
a general introduction, and §§1.263(g)-2, 1.263(g)-3,
1.263(g)-4, and 1.263(g)-5, described below. The proposed
regulations also include a new paragraph 1.1092(d)-1(d).

The proposed regulations generally address four issues: (1) the
definition of personal property as such term is used in section
263(g) (in §1.263(g)-2); (2) the type of payments that are
subject to the capitalization rules of section 263(g) (in
§1.263(g)-3); (3) the operation of the capitalization rules of
section 263(g) (in §1.263(g)-4); and (4) the circumstances
under which an issuer's obligation under a debt instrument can be a
position in actively traded personal property and, therefore, part
of a straddle (in §1.1092(d)-1(d)). These issues are discussed
in more detail below.

Definition of the Term Personal Property for Purposes of Section
263(g)

Section 263(g)(1) requires capitalization of interest and carrying
charges properly allocable to personal property that is part of a
straddle (as defined in section 1092(c)). Section 1092(d)(1) defines
personal property for purposes of section 1092, as personal property
of a type that is actively traded. Commentators have suggested that
because sections 263(g) and 1092 were enacted at the same time, the
term personal property as used in section 263(g) should be given the
same definition under section 1092(d)(1). This would limit the
definition of personal property in section 263(g) to personal
property of a type that is actively traded. Despite this suggestion,
the proposed regulations provide that personal property has its
common law meaning in section 263(g) for two reasons. First, the
definition in section 1092(d)(1) by its terms applies only for
purposes of section 1092. Second, the broader, common law
interpretation of personal property more closely accords with the
purposes of section 263(g). Application of the limited definition in
section 1092(d)(1) for purposes of section 263(g) could result in
dissimilar tax treatment of economically similar transactions. For
example, adoption of the narrower definition would cause section
263(g) to apply to a transaction in which a taxpayer borrows to
purchase actively traded personal property that is a part of a
straddle but not to a similar transaction in which the taxpayer
borrows to purchase a derivative instrument that is not itself
actively traded but is a position in actively traded property.

Consequently, proposed §1.263(g)-2 defines personal property as
a property right, whether or not actively traded, other than a right
in real property. This definition includes both financial positions
that provide substantial rights but do not impose substantial
obligations on the holder (e.g., common stock or a purchased option)
and executory contracts that impose both rights and obligations on
the holder (e.g., notional principal contracts (NPC's) and forward
transactions). However, the definition excludes straddles comprised
only of financial positions that impose only obligations on the
holder (e.g., the obligor's position in a debt instrument or a
writer's position in an option).

Payments That Are Subject to the Capitalization Rules of Section
263(g)

Section 263(g)(1) provides for the capitalization of interest and
carrying charges. For this purpose, interest and carrying charges
are collectively defined in section 263(g)(2) as "interest incurred
or continued to purchase or carry the personal property" and "all
other amounts (including charges to insure, store, or transport)
paid or incurred to carry the personal property," less certain types
of income from the personal property.

The phrase "incurred or continued to purchase or carry" also appears
in section 265(a)(2), which disallows interest expense on
indebtedness incurred or continued to purchase or carry tax-exempt
debt. Rev. Proc. 72-18 (1972-1 C.B. 740) sets out rules for
determining when this standard is met for purposes of section 265(a)
(2). Under that revenue procedure, indebtedness issued by a taxpayer
that is not a dealer in tax-exempt obligations meets this standard
if (1) the proceeds of the indebtedness are directly traceable to
the purchase of the tax-exempt obligations, (2) the tax-exempt
obligations are used as collateral for the borrowing, or (3) the
totality of the facts and circumstances supports a reasonable
inference that the purpose of the borrowing was to purchase or carry
tax-exempt obligations. In general, the facts-and-circumstances test
is met if there is a "sufficiently direct relationship" between the
borrowing and the investment in the tax-exempt obligations.
Similarly, the proposed regulations provide that a sufficiently
direct relationship between indebtedness or other financing and
personal property that is part of a straddle exists if payments on
the indebtedness or other financing are determined by reference to
the value or change in value of the personal property. See
§1.263(g)-3(c).

Section 263(g) also applies to "all other amounts (including charges
to insure, store or transport the personal property)" paid or
incurred to carry personal property that is part of a straddle. As
noted by one commentator, "taxpayers should not be permitted to
deduct items incurred in connection with protecting or preserving
the value of assets" that are part of a straddle. Therefore, the
term, to carry in the context of section 263(g) includes the
reduction of the risk of holding an asset. Because straddles
necessarily involve positions that offset each other, the positions
"carry" each other.

Accordingly, under §1.263(g)-3(b) of the proposed regulations,
interest and carrying charges subject to capitalization under
section 263(g) include: (1) otherwise deductible payments or
accruals (including interest and original issue discount) on
indebtedness or other financing issued or continued to purchase or
carry personal property that is part of a straddle; (2) otherwise
deductible fees or expenses paid or incurred in connection with the
taxpayer's acquiring or holding personal property that is part of a
straddle, including, but not limited to, fees or expenses incurred
to purchase, insure, store, maintain, or transport the personal
property; and (3) other otherwise deductible payments or accruals on
financial instruments that are part of a straddle or that carry part
of a straddle.

Section 263(g) requires capitalization of interest and carrying
charges that exceed certain specified income inclusions (allowable
offsets) listed in section 263(g)(2)(B). Section 1.263(g)-3(e) sets
forth the allowable offsets, including amounts that are receipts or
accruals on financial instruments that are part of a straddle or
carry part of a straddle. The Treasury Department and the IRS
solicit comments regarding whether other amounts should be treated
as allowable offsets for purposes of section 263(g).

Operation of the Capitalization Rules of Section 263(g)

Generally, section 263(g) coordinates the character and timing of
items of income and loss attributable to a taxpayer's position in a
straddle by allocating interest and carrying charges to the capital
account of a position in personal property that is part of the
straddle. Proposed regulation §1.263(g)-4 provides a set of
allocation rules governing the "capitalization" of interest and
carrying charges.

In many cases, certain allocation rules readily suggest themselves.

Congress was aware of "cash and carry" transactions in adopting
section 263(g). See H.R. Rep. No. 201, 97th Cong. 1st Sess. 203-04
(1981). In a typical transaction, a taxpayer borrows to purchase
personal property and sells the property forward. The debt
instrument generates ordinary deductions (interest expense) that
precede predictable (and approximately equal) capital gains on the
sale of the personal property. Coordination of the amount and timing
of income and loss in a cash and carry transaction is achieved under
the proposed regulation by allocating the interest expense to the
capital account of the personal property. This rule applies to all
transactions in which a taxpayer has borrowed to purchase personal
property that is part of a straddle.

If the proceeds of a borrowing are not used to purchase personal
property, a second allocation rule allocates interest expense to
personal property when the personal property collateralizes the
borrowing. See Rev. Proc. 72-18, §3.03 (disallowing interest
deduction for debt secured by tax-exempt obligations); Rev. Rul.
78-348 (1978-2 C.B. 95) (applying yield restrictions to investments
pledged by person benefitting from tax-exempt bond financing). A
third allocation rule of the proposed regulations allocates interest
on indebtedness to personal property when payments on the
indebtedness are determined by reference to the value, or change in
value, of the personal property that is part of a straddle.

Fees and charges related to the maintenance of the personal
property, such as charges to insure, store, or transport the
personal property, are allocated to the capital account of that
personal property. See S. Rep. No. 144, 97th Cong. 1st Sess. 154
(1981).

In other cases, the appropriate method for allocating capitalized
interest and carrying charges is less obvious. This may be true of
payments or accruals on a financial instrument, such as a NPC,
described in proposed §1.263(g)-3(d). For example, the proposed
rules would apply to a taxpayer that holds stock and enters into an
equity swap that is a short position with respect to the stock. In
such a case, both the stock and the equity swap may be personal
property that is part of a straddle, and payments on the equity swap
could be capitalized with respect to the capital account of either
the stock or the equity swap. However, it may not be clear how a
capitalization rule would apply in conjunction with the rules under
§1.446-3 with respect to payments on NPCs. Accordingly, the
proposed rules provide that, in cases to which a specific allocation
rule is not applicable, interest and carrying charges will be
allocated to personal property that is part of a straddle in the
manner that is most appropriate under all the facts and
circumstances. Proposed regulations §1.263(g)-4(c) Example 7
(relating to a straddle consisting of stock and an equity swap)
illustrate one application of this facts and circumstances rule. The
Treasury Department and the IRS invite comments and suggestions
regarding both the proposed specific allocation rules and the
general facts and circumstances allocation rule. The regulations
under section 263(g) are proposed to be effective for expenses paid,
incurred, or accrued after the date the regulations are adopted as
final for straddles established on or after January 17, 2001. See
§1.263(g)-5.

Obligation Under a Debt Instrument as a Position in Personal
Property

If a taxpayer is the obligor under a debt instrument that provides
for one or more payments linked to the value of actively traded
personal property, the value of the taxpayer's obligation under the
debt instrument changes as the value of the referenced property
changes. For this reason, the taxpayer's position as obligor under
the debt instrument functions as a position in the referenced
property.

Some commentators have suggested that a debt instrument (other than
one denominated in an actively traded foreign currency) cannot be a
position of the obligor in personal property that is part of a
straddle. Section 1092(d)(7) provides that an obligor's interest in
a nonfunctional-currency-denominated debt instrument is treated
under section 1092(d)(2) as a position in the nonfunctional
currency. From this, the commentators infer that an obligor's
interest in a debt instrument may never be treated as an interest in
personal property other than a nonfunctional currency.

However, neither the legislative history nor the express language of
section 1092(d)(7) indicates that Congress intended to exclude
interests in personal property from the definition of position in
section 1092(d)(2). A rule that a debt instrument can be a position
in currency does not establish that a debt instrument is a position
only in currency. This interpretation of section 1092(d)(7) has
already been rejected by the IRS and Treasury in §1.1275-4(b)
(9) (vi), which provides that increased interest expense on a
contingent payment debt instrument issued by a taxpayer may be a
straddle loss subject to section 1092 deferral.

To clarify the definition of position under section 1092(d)(2),
§1.1092(d)-1(d) of the proposed regulations explicitly provides
that an obligation under a debt instrument may be a position in
personal property that is part of a straddle. This provision is
proposed to be effective for straddles established on or after
January 17, 2001. However, no inference is intended with respect to
straddles established prior to January 17, 2001. Thus, in
appropriate cases, the IRS may take the position under section
1092(d)(2) that, even in the absence of a regulation, an obligation
under a debt instrument was part of a straddle prior to the
effective date of §1.1092(d)-1(d) if the debt instrument
functioned economically as an interest in actively traded personal
property.

In 1995, the IRS published proposed regulation §1.1092(d)-(2).
See 60 F.R. 21482; FI-21-95, 1995-1 C.B. 935. The proposed
regulations clarify the circumstances in which common stock may be
personal property for the purposes of section 1092. Because proposed
regulation §§1.1092(d)-2 and 1.1092(d)-1(d) address
similar issues, the IRS proposes to finalize both regulations
simultaneously. The Treasury Department and the IRS, therefore,
invite additional comment on proposed §1.1092(d)-(2).

In addition, in 1985, the Treasury Department and the IRS adopted
Temporary Regulation §1.1092(d)-5T(d), which defines the term
loss for purposes of §§1.1092(b)-1T through 1.1092(b)-4T
as a loss otherwise allowable under section 165(a). The Treasury
Department and the IRS request comments on whether that definition
should be expanded to include expenses such as interest and carrying
charges or payments on notional principal contracts. If so, how
should such a change be coordinated with the proposed regulations in
this document?

Special Analyses

It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It also
has been determined that section 553(b) of the Administrative
Procedure Act (5 U.S.C. chapter 5) does not apply to these
regulations, and because the regulation does not impose a collection
of information on small entities, the Regulatory Flexibility Act (5
U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the
Internal Revenue Code, this notice of proposed rulemaking will be
submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,
consideration will be given to any written or electronic comments (a
signed original and eight (8) copies, if written) that are submitted
timely (in the manner described in the ADDRESSES portion of this
preamble) to the IRS. The IRS and Treasury request comments on the
clarity of the proposed regulations and how they may be made easier
to understand. All comments will be available for public inspection
and copying.

A public hearing has been scheduled for May 22, 2001, at 10 a.m. in
the Auditorium, Internal Revenue Building, 1111 Constitution Avenue
NW., Washington DC. Due to building security procedures, visitors
must enter at the 10th Street entrance located between Constitution
and Pennsylvania Avenues, NW. In addition, all visitors must present
photo identifications to enter the building. Because of access
restrictions, visitors will not be admitted beyond the immediate
entrance area more than 15 minutes before the hearing starts. For
information about having your name placed on the building access
list to attend the hearing, see the "FOR FURTHER INFORMATION
CONTACT" section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must submit and an
outline of the topics to be discussed and the time to be devoted to
each topic (signed original and eight (8) copies) by May 1, 2001. A
period of 10 minutes will be allotted to each person for making
comments. An agenda showing the scheduling of the speakers will be
prepared after the deadline for receiving outlines has passed.
Copies of the agenda will be available free of charge at the
hearing.

The principal author of these regulations is Kenneth Christman,
Office of Associate Chief Counsel (Financial Institutions and
Products). However, other personnel from the IRS and Treasury
Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations Accordingly, 26 CFR part 1 is
proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding
entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.263(g)-1 also issued under 26 U.S.C. 1092(b)(1). 
Section 1.263(g)-2 also issued under 26 U.S.C. 1092(b)(1).
Section 1.263(g)-3 also issued under 26 U.S.C. 1092(b)(1).
Section 1.263(g)-4 also issued under 26 U.S.C. 1092(b)(1).
Section 1.263(g)-5 also issued under 26 U.S.C. 1092(b)(1).
Section 1.1092(d)-1 also issued under 26 U.S.C. 1092(b)(1).

Par. 2. Sections 1.263(g)-1, 1.263(g)-2, 1.263(g)-3, 1.263(g)-4, and
1.263(g)-5 are added to read as follows:

§1.263(g)-1 Treatment of interest and carrying charges in the
case of straddles; in general.

(a) Under section 263(g), no deduction is allowed for interest and
carrying charges allocable to personal property that is part of a
straddle (as defined in section 1092(c)). The purpose of section
263(g) is to coordinate the character and the timing of items of
income and loss attributable to a taxpayer's positions that are part
of a straddle. In order to prevent payments or accruals related to a
straddle transaction from giving rise to recognition of deductions
or losses before related income is recognized and to prevent the
items of loss and income from having different character, no
deduction is allowed for interest and carrying charges properly
allocable to personal property that is part of a straddle. Rather,
such amounts are chargeable to the capital account of the personal
property to which the interest and carrying charges are properly
allocable.

(b) Section 263(g) does not apply if none of the taxpayer's
positions that are part of the straddle are personal property.
Section 263(g) also does not apply to hedging transactions as
defined in section 1256(e) (see section 263(g)(3)) or to securities
to which the mark-to-market accounting method provided by section
475 applies (see section 475(d)(1)).

(C) Section 1.263(g)-2 provides a definition of personal property
for purposes of section 263(g) and §§1.263(g)-1 through
1.263(g)-5. Section 1.263(g)-3 provides a definition of interest and
carrying charges for purposes of section 263(g), section 1092,
§§1.263(g)-1 through 1.263(g)-5, and §1.1092(b)-4T.
Section 1.263(g)-4 provides a set of allocation rules governing the
capitalization of amounts to which section 263(g) applies.

§1.263(g)-2 Personal property to which interest and carrying
charges may properly be allocable.

(a) Definition of personal property. For purposes of section 263(g)
and of §§1.263(g)-1 through 1.263(g)-5, personal property
means property, whether or not actively traded, that is not real
property. For purposes of the preceding sentence, a position in
personal property may itself be property. In general, however, a
position in personal property is not property of a taxpayer unless
the position confers or may confer substantial rights on the
taxpayer.

(1) Application to certain financial instruments. Personal property
includes a stockholder's ownership of common stock, a holder's
ownership of a debt instrument, and either party's position in a
forward contract or in a conventional swap agreement. Personal
property does not include a position that imposes obligations but
does not confer substantial rights on the taxpayer. Therefore, the
obligor's position in a debt instrument generally is not personal
property, even though the obligor may have typical rights of a
debtor, such as the right to prepay the debt. However, the obligor
on a debt instrument has a position in any personal property
underlying the debt instrument. See §1.1092(d)-1(d).

(2) Options. For the purposes of applying this section, a put option
or call option imposes obligations but does not confer substantial
rights on the grantor, whether or not the option is cash-settled.

(b) Example. The following example illustrates the rules stated in
paragraph (a) of this section:

Example.

(i) Facts. A purchases 100 ounces of gold at a cost of $x. A
transfers the 100 ounces of gold to a trust that issues multiple
classes of trust certificates and is treated as a partnership for
tax purposes. In return, A receives two trust certificates that are
not personal property of a type that is actively traded within the
meaning of section 1092(d)(1). One certificate entitles A to a
payment on termination of the trust at the end of four years equal
to the value of the 100 ounces of gold up to a maximum value of $(x
+ y). The other certificate entitles A to a payment equal to the
amount by which the value of 100 ounces of gold exceeds $(x + y) on
termination of the trust. A sells the second certificate and keeps
the first certificate.

(ii) Analysis. The trust certificate retained by A is property that
is not real property. In addition, ownership of the trust
certificate confers certain substantial rights on A. Therefore,
although the trust certificate is not personal property of a type
that is actively traded, A's interest in the trust certificate is
personal property for purposes of section 263(g).

§1.263(g)-3 Interest and carrying charges properly allocable to
personal property that is part of a straddle.

(a) In general. For purposes of section 263(g), section 1092,
§§1.263(g)-1 through 1.263(g)-5, and §1.1092(b)-4T,
interest and carrying charges properly allocable to personal
property that is part of a straddle means the excess of interest and
carrying charges (as defined in paragraph (b) of this section) over
the allowable income offsets (as defined in paragraph (e) of this
section).

(b) Interest and carrying charges. Interest and carrying charges are
otherwise deductible amounts paid or accrued with respect to
indebtedness or other financing incurred or continued to purchase or
carry personal property that is part of a straddle and otherwise
deductible amounts paid or incurred to carry personal property that
is part of a straddle. As provided in section 263(g)(2), interest
includes any amount paid or incurred in connection with personal
property used in a short sale. Interest and carrying charges
include--

(1) Otherwise deductible payments or accruals (including interest
and original issue discount) on indebtedness or other financing
issued or continued to purchase or carry personal property that is
part of a straddle;

(2) Otherwise deductible fees or expenses paid or incurred in
connection with acquiring or holding personal property that is part
of a straddle including, but not limited to, fees or expenses
incurred to purchase, insure, store, maintain or transport the
personal property; and

(3) Other otherwise deductible payments or accruals on financial
instruments that are part of a straddle or that carry part of a
straddle.

(c) Indebtedness or other financing incurred or continued to
purchase or carry personal property that is part of a straddle. For
purposes of paragraph (b)(1) of this section, indebtedness or other
financing that is incurred or continued to purchase or carry
personal property that is part of a straddle includes --

(1) Indebtedness or other financing the proceeds of which are used
directly or indirectly to purchase or carry personal property that
is part of the straddle;

(2) Indebtedness or other financing that is secured directly or
indirectly by personal property that is part of the straddle; and

(3) Indebtedness or other financing the payments on which are
determined by reference to payments with respect to the personal
property or the value of, or change in value of, the personal
property.

(d) Financial instruments that are part of a straddle or that carry
part of a straddle. For purposes of paragraph (b)(3), financial
instruments that are part of a straddle or that carry part of a
straddle include --

(1) A financial instrument that is part of the straddle;

(2) A financial instrument that is issued in connection with the
creation or acquisition of a position in personal property if that
position is part of the straddle;

(3) A financial instrument that is sold or marketed as part of an
arrangement that involves a taxpayer's position in personal property
that is part of the straddle and that is purported to result in
either economic realization of all or part of the appreciation in an
asset without simultaneous recognition of taxable income or a
current tax deduction (for interest, carrying charges, payments on a
notional principal contract, or otherwise) reflecting a payment or
expense that is economically offset by an increase in value that is
not concurrently recognized for tax purposes or has a different tax
character (for example, an interest payment that is economically
offset by an increase in value that may result in a capital gain in
a later tax period); and

(4) Any other financial instrument if the totality of the facts and
circumstances support a reasonable inference that the issuance,
purchase, or continuation of the financial instrument by the
taxpayer was intended to purchase or carry personal property that is
part of the straddle.

(e) Allowable income offsets. The allowable income offsets are:

(1) The amount of interest (including original issue discount)
includible in gross income for the taxable year with respect to such
personal property;

(2) Any amount treated as ordinary income under section 1271(a)(3)
(A), 1278, or 1281(a) with respect to such personal property for the
taxable year;

(3) The excess of any dividends includible in gross income with
respect to such property for the taxable year over the amount of any
deductions allowable with respect to such dividends under section
243, 244, or 245;

(4) Any amount that is a payment with respect to a security loan
(within the meaning of section 512(a)(5)) includible in income with
respect to the personal property for the taxable year; and

(5) Any amount that is a receipt or accrual includible in income for
the taxable year with respect to a financial instrument described in
§1.263(g)-3(d) to the extent the financial instrument is
entered into to purchase or carry the personal property.

§1.263(g)-4 Rules for allocating amounts to personal property
that is part of a straddle.

(a) Allocation rules.

(1) Interest and carrying charges paid or accrued on indebtedness or
other financing issued or continued to purchase or carry personal
property that is part of a straddle are allocated, in the order
listed --

(i) To personal property that is part of the straddle purchased,
directly or indirectly, with the proceeds of the indebtedness or
other financing;

(ii) To personal property that is part of the straddle and directly
or indirectly secures the indebtedness or other financing; or

(iii) If all or a portion of such interest and carrying charges are
determined by reference to the value or change in value of personal
property, to such personal property.

(2) Fees and expenses described in §1.263(g)-3(b)(2) are
allocated to the personal property, the acquisition or holding of
which resulted in the fees and expenses being paid or incurred.

(3) In all other cases, interest and carrying charges are allocated
to personal property that is part of a straddle in the manner that
under all the facts and circumstances is most appropriate.

(b) Coordination with other provisions. In the case of a short sale,
section 263(g) applies after section 263(h). See sections 263(g)(4)
(A) and (h)(6). In case of an obligation to which section 1277
(dealing with deferral of interest deduction allocable to accrued
market discount) or 1282 (dealing with deferral of interest
deduction allocable to certain accruals on short-term indebtedness)
applies, section 263(g) applies after section 1277 and section 1282.
See section 263(g)(4)(B). Capitalization under section 263(g)
applies before loss deferral under section 1092.

(c) Examples. The following examples illustrate the rules stated in
§§1.263(g)-2, 1.263(g)-3, and 1.263(g)-4.

Example 1. Cash and Carry Silver.

(i) Facts. On January 1, 2002, A borrows $x at 6% interest and uses
the proceeds to purchase y ounces of silver from B. At approximately
the same time, A enters into a forward contract with C to deliver y
ounces of silver to C in one year.

(ii) Analysis. The y ounces of silver and the forward contract to
deliver y ounces of silver in one year are offsetting positions with
respect to the same personal property and therefore constitute a
straddle. See sections 1092(c)(1), (c)(3)(A)(i). The proceeds of the
debt instrument were used to purchase personal property that is part
of the straddle. Consequently, A's interest payments are interest
and carrying charges properly allocable to personal property that is
part of a straddle. See §1.263(g)-3(b)(1) & (c)(1). Under
§1.263(g)-4(a)(1)(i), the interest payments must be charged to
the capital account for the y ounces of silver purchased by A with
the proceeds of the borrowing.

Example 2. Additional indebtedness issued to carry personal
property.

(i) Facts. The facts are the same as for Example 1 except that
during the year 2002, the market price of silver increases and A is
required to post variation margin as security for its obligation to
deliver y ounces of silver to C. A incurs additional indebtedness to
obtain funds necessary to meet A's variation margin requirement.

(ii) Analysis. The additional indebtedness is incurred to continue
to carry A's holding of y ounces of silver. Consequently, A's
interest payments on the additional indebtedness are interest and
carrying charges properly allocable to personal property that is
part of a straddle and must be charged to the capital account for
the y ounces of silver.

Example 3. Contingent payment debt instrument.

(i) Facts. On January 1, 2002, D enters into a contract to deliver x
barrels of fuel oil to E on July 1, 2004, at an aggregate price
equal to $y. Soon afterward, D issues a contingent payment debt
instrument to F with a principal amount of $z and a 2-year term that
pays interest quarterly at a rate determined at the beginning of
each quarter equal to the greater of zero and the London Interbank
Offered Rate (LIBOR) adjusted by an index that varies inversely with
changes in the price of fuel oil (so that the interest rate
increases as the price of fuel oil decreases and vice versa). The
change in the aggregate amount of interest paid on the $z of debt
due to the functioning of the index approximates the concurrent
aggregate change in value of x barrels of fuel oil and, thus, the
value of D's interest in the forward contract.

(ii) Analysis. The debt instrument and the forward contract are
offsetting positions with respect to the same personal property and
constitute a straddle. See section 1092(c)(1), (c)(3)(A)(i). When
issued, the debt instrument is a position in personal property that
is part of a straddle. See §1.1092(d)-1(d). Consequently, D's
interest payments are interest and carrying charges properly
allocable to personal property that is part of a straddle and must
be allocated to the capital account for the forward contract for the
delivery of x barrels of fuel oil to E. See
§§1.263(g)-3(b)(1), (b) (3), (c)(3), and (d)(1) and -4(a)
(1)(iii).

Example 4. Financial instrument issued to carry personal property
that is part of a straddle.

(i) Facts. The facts are the same as for Example 3 except that D
also enters into a two-year interest rate swap under which D
receives LIBOR times a notional principal amount equal to $z and
pays 7% times $z.

(ii) Analysis. Because of the relationship between the two-year debt
instrument issued by D and the interest rate swap, the interest rate
swap is a financial instrument that carries personal property that
is part of a straddle. See §1.263(g)-3(d)(4). Net payments made
by D under the interest rate swap are chargeable to the capital
account for the forward contract for the delivery of x barrels of
fuel oil to E. Similarly, net payments received by D under the
interest rate swap are allowable offsets. See §1.263(g)-3(e)
(5).

Example 5. Contingent payment debt instrument with embedded short
position.

(i) Facts. On January 1, 1998, G purchases 100,000 shares of the
common stock of XYZ corporation (which is publicly traded). On
January 1, 2002, the 100,000 shares of XYZ corporation common stock
were worth $x per share. On that date, G issued a contingent payment
debt instrument for $100,000x. The terms of the debt instrument
provided that the holders would receive an annual payment of $2,000x
on December 31 of each year up to and including the maturity date of
December 31, 2007. On the maturity date, the holders would also
receive a payment of $100,000x plus an additional amount, if the
price of an XYZ share exceeded $1.2x on such date, equal to 100,000
times three-quarters of the amount of such excess per share. Thus,
G's aggregate payments on the debt instrument varied directly with
the increase in value in the XYZ shares.

(ii) Analysis. The debt instrument is a position in XYZ stock. See
§1.1092(d)-1(d). The XYZ stock is personal property within the
meaning of section 1092(d)(3)(B) because the debt instrument is a
position with respect to substantially similar or related property
(other than stock) within the meaning of section 1092(d)(3)(B)(i)
(II). See §1.1092(d)-2(c). The debt instrument and the XYZ
shares are offsetting positions with respect to the same personal
property and constitute a straddle. See sections 1092(c)(1), (c)(3)
(A)(i). Consequently, G's interest payments are interest and
carrying charges properly allocable to personal property that is
part of a straddle, see §§1.263(g)-3(b)(1), (b)(3), (c)
(3), and (d)(1), and must be allocated to the capital account for
the XYZ common stock, see §1.263(g)-4(a)(1)(iii) and (a)(3).

Example 6. Straddle including partnership interest.

(i) Facts. H borrows money from I to purchase 100 ounces of gold at
a cost of $u. H transfers the 100 ounces of gold and $v to a newly
created trust that issues multiple classes of trust certificates and
is treated as a partnership for tax purposes. In return, H receives
two trust certificates. One certificate entitles the holder to a
payment on termination of the trust at the end of four years equal
to the value of the 100 ounces of gold up to a maximum value of $(u
+ w). The other certificate entitles the holder to a payment equal
to the amount by which the value of 100 ounces of gold exceeds $(u +
w) on termination of the trust. H sells the second certificate and
keeps the first certificate. H also enters into a forward contract
to sell 100 ounces of gold for $1.12u per ounce on a date two years
after creation of the trust. The trust uses part of the $v and
similar cash contributions from other investors to pay costs of
storing the gold held by the trust and allocates H's share of the
expenses to H.

(ii) Analysis. The trust certificate retained by H and the forward
contract entered into by H are personal property for the purposes of
section 263(g). See §1.263(g)-2(a). They are also offsetting
positions and constitute a straddle. Section 1092(c)(1). The
borrowing from I is an indebtedness incurred to purchase personal
property that is part of a straddle. See §§1.263(g)-3(b)
(1) and (c) (1). Similarly, the gold storage expenses are expenses
incurred due to the taxpayer's holding personal property that is
part of a straddle. See §1.263(g)-3(b)(2). Therefore both the
interest on the borrowing and the gold storage expenses must be
allocated to the capital account for the partnership interest
represented by the retained trust certificate. See
§1.263(g)-4(a)(1)(i) and (a)(2).

Example 7. Equity Swap.

(i) Facts. On January 1, 1998, J purchases 100,000 shares of the
common stock of XYZ corporation (which is publicly traded). On
December 31, 2001, the 100,000 shares of XYZ corporation common
stock were worth $x per share. On that date, J entered into a NPC
with K. The terms of the NPC provided that K would receive an annual
payment on December 31 of each year equal to 100,000 times any
appreciation in the value of a share of XYZ corporation stock above
its price at the end of trading on December 31 of the preceding year
and 100,000 times the dividends paid during the year on each share
of XYZ corporation stock. In return, on December 31 of each year, J
would receive an amount equal to LIBOR times the value of 100,000
XYZ shares at the end of trading on December 31 of the preceding
year plus 100,000 times the amount of any decrease in the value of a
share of XYZ corporation stock below its price at the end of trading
on December 31 of the preceding year. Payments between J and K would
be netted and continue up to and including the maturity date of the
NPC on December 31, 2008. Thus, J's aggregate payments on the NPC
varied directly with the increase in value in the XYZ shares.

(ii) Analysis. The NPC is a position in XYZ stock. See
§1.1092(d)-2(c). The XYZ stock is personal property within the
meaning of section 1092(d)(3)(B) because the NPC is a position with
respect to substantially similar or related property (other than
stock) within the meaning of section 1092(b)(3)(B)(i)(II). See
§1.1092(d)-2(a)(1)(ii). The NPC and the XYZ shares are
offsetting positions with respect to the same personal property and
constitute a straddle. See sections 1092(c)(1), (c)(3)(A)(i).
Consequently, J's payments are interest and carrying charges
properly allocable to personal property that is part of a straddle.
See §§1.263(g)-3(b)(3) and (d)(1). Therefore, they should
be allocated to the personal property that is part of the straddle
in the manner that is most appropriate under all the facts and
circumstances. In this case, because these payments are incurred to
carry the XYZ shares, they should be allocated to the capital
account for the XYZ common stock. See §1.263(g)-4(a)(3).

§1.263(g)-5 Effective dates.

Sections 1.263(g)-1, 1.263(g)-2, 1.263(g)-3, and 1.263(g)-4 apply to
interest and carrying charges properly allocable to personal
property that are paid, incurred, or accrued after the date these
regulations are adopted as final regulations by publication in the
Federal Register for a straddle established on or after January 17,
2001.

Par. 3. Section 1.1092(d)-1 is amended by revising paragraph (d) and
adding paragraph (e), to read as follows:

§1.1092(d)-1 Definitions and special rules.

* * * * *

(d) Debt instrument linked to the value of personal property. If a
taxpayer is the obligor under a debt instrument one or more payments
on which are linked to the value of personal property or a position
with respect to personal property, then the taxpayer's obligation
under the debt instrument is a position with respect to personal
property and may be part of a straddle.

(e) Effective dates. Paragraph (b)(1)(vii) of this section applies
to positions entered into on or after October 14, 1993. Paragraph
(c) of this section applies to positions entered into on or after
July 8, 1991. Paragraph (d) of this section is effective for
straddles established on or after January 17, 2001.

Robert E. Wenzel
Deputy Commissioner of Internal Revenue.

SEARCH:

You can search the entire Tax Professionals section, or all of Uncle Fed's Tax*Board. For a more focused search, put your search word(s) in quotes.

2001 Regulations Main | IRS Regulations Main | Home